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Today I was asked to do an interview with a Danish radio station about Donald Trump and about whether one could say anything positive about him or rather about his economic agenda. I declined to do the interview. I frankly speaking has nothing positive to say about Trump.

To me Donald Trump is an absolutely vile person and and his views on immigration and trade are completely the opposite of mine. However, I have also in the run up to the election in presentations and comments stressed that the presidential election from an overall financial market perspective would not be a big deal and judging from the market reaction today this indeed seems to be the case.

Reading the markets

But what exactly are the markets telling us today about the economic consequences of a Trump presidency combined with the fact that GOP now has the majority in both the House and the Senate?

First, of all we should concluded that the markets are fairly relaxed about the outcome of the election. This to me is an indication that Trump really will never be able (or seriously want to) implement many of the bizarre “promises” on trade and immigration he made during the election campaign.

Second the markets certainly do not expect the outcome of the election to cause a US recession or a global economic crisis. After all US stock markets are in fact trading in positive territory today. We get the same message from the currency markets where the dollar is little changed over the past 24 hours.

The Republican Keynesians

However, there is one market where we have seen a significant reaction to the outcome of the election and that is in the bond market. Just take a look at the graphs below.

The first graph is the yield on 10-year Treasury bonds and the second graph is 2-year yields.

We see that the 10-yield has increased around 10bp overnight. This certainly is a significant reaction, but it is equally notable that 2-yields in fact is slightly down.

What this is telling me is that more than anything else the markets expect Trump to be an old-school Keynesian. We know that Trump has already promised to increase Federal spending on infrastructure and he has of course also promised major tax cuts. With the Republicans controlling both the House and the Senate he should be able to deliver on some of these promises.

In fact there would be nothing unusual about having a Republican president who is also a “keynesian” (yes, I know he has no clue about what that is). In fact historically public spending has grown faster under Republican administrations than under Democrat administrations. Just take a look at the graphs below.

Since the Second World War public spending has grown by around a quarter of a percent per year faster when the president has been Republican than when there has been a Democrat president.

The picture is even more clear when we look at Federal government investments:

…and on the budget deficit:

So based on history we can certainly say that Republican presidents tend to be less fiscally conservative than Democrat presidents and judging from the action in the bond markets today there is little reason to believe that Trump should be any different from former Republican presidents.

And what will Trump spend money on? There is little doubt what the markets think – infrastructure! This is from Trump’s victory speech:

We are going to fix our inner cities, and rebuild our highways, bridges, tunnels, airports, schools, hospitals,” he said. “We’re going to rebuild our infrastructure, which will become, by the way, second to none. And we will put millions of our people to work as we rebuild it.

And see what effect that kind of speech had on copper prices today:

Keynesian president + Keynesian Fed chair = No monetary offset

So it seems like the markets expect Trump to push for an expansionary fiscal policy agenda and this is visible in the bond market. However, it is also notable that it is only long-term bond yields, which have increased while 2-year yields haven’t increased overnight.

That tells me that the markets do not expect the Federal Reserve to (fully) offset the impact on nominal demand from a more expansionary fiscal policy.

This effectively means that an easier fiscal policy stance will cause monetary conditions to be eased. The reason is that if fiscal policy is eased then that will push up the equilibrium interest rate level. If the Fed does not hike interest rates to reflect this then it will automatically ease monetary policy by keeping the fed funds rate below the equilibrium interest rate.

This of course is the standard result in a New Keynesian model when interest rates are at the Zero Lower Bound (see for example here).

Does this mean that the so-called Sumner Critique does not apply? According to the Sumner Critique an easing of fiscal policy will not have (net) impact on aggregate demand if the central bank has an inflation target (or a nominal GDP) as the central bank will act to offset any impact on aggregate demand from a easier fiscal policy.

However, the Sumner Critique does not necessarily apply if the central bank’s inflation target is not credible and/or central bank is not willing to “enforce” it. And this seems relevant to the present situation. Hence, US core inflation continue to be below the Fed’s inflation target so one can certainly argue that there is room for an increase in aggregate demand without the Federal Reserve having to tighten monetary conditions.

Obviously the Fed could have done this on it own by for example not signaling a rate hike in December or signaling that it would re-introduce quantitative easing if inflation once again started to trend downwards.

However, the Fed clearly has “mental” problems with this. It is clear that most key Fed policy makers are worried about the consequences of keeping interest rates “low for longer” and more QE clearly seems to be a no-go.

In other words the Fed has put itself in a situation where further monetary easing is off the table and this is of course the reason why a number of Fed officials in the last couple of months have called for old-school keynesian fiscal stimulus.

It all seems to have started in August. This is Janet Yellen at the Jackson Hole symposium on August 26:

Beyond monetary policy, fiscal policy has traditionally played an important role in dealing with severe economic downturns. A wide range of possible fiscal policy tools and approaches could enhance the cyclical stability of the economy.25 For example, steps could be taken to increase the effectiveness of the automatic stabilizers, and some economists have proposed that greater fiscal support could be usefully provided to state and local governments during recessions. As always, it would be important to ensure that any fiscal policy changes did not compromise long-run fiscal sustainability.

Finally, and most ambitiously, as a society we should explore ways to raise productivity growth. Stronger productivity growth would tend to raise the average level of interest rates and therefore would provide the Federal Reserve with greater scope to ease monetary policy in the event of a recession. But more importantly, stronger productivity growth would enhance Americans’ living standards. Though outside the narrow field of monetary policy, many possibilities in this arena are worth considering, including improving our educational system and investing more in worker training; promoting capital investmentand research spending, both private and public; and looking for ways to reduce regulatory burdens while protecting important economic, financial, and social goals.

Since August we have heard this again and again from Fed officials. This is Federal Reserve Vice Chairman Stanley Fischer at the New York Economic Club on October 17:

Some combination of more encouragement for private investment, improved public infrastructure, better education, and more effective regulation is likely to promote faster growth of productivity and living standards.

Said in another way – the Fed chair and the Vice chairman are both old-school keynesians and now we will have a keynesian in the White House as well.

The consequence is that if we get massive government infrastructure investments then that will push up the equilibrium interest rate, which will allow the Fed to hike interest rates (which they for some reason so desperately want to) without really tightening monetary conditions if interest rates are increased slower than the increase in the equilibrium rate.

This means that we de facto could have a keynesian alliance between the Trump administration and the Federal Reserve, which would mean that will get both monetary and fiscal easing in 2017 and this might be what the markets now are realizing.

Just take a look at what have happened in 5-year/5-year inflation expectations over the paste 24 hours:

Over the past 24 hours long-term inflation expectations hence have increased by nearly a quarter of a percentage point.

Hence, Donald Trump just eased US monetary conditions significantly by pushing down the difference between the Fed fund target rate and the equilibrium rate. Paul Krugman should love Donald Trump.

The Sumner Critique strikes back – A future conflict between the Fed and Trump?

Obviously this is only possible because the Federal Reserve has not been willing to ensure nominal stability by clearly defining its nominal target and has been overly eager to increase interest rates, but I do think that this keynesian stimulus implemented could increase aggregate demand in 2017 and likely push core inflation above 2%.

But if this happens then the keynesian alliance between the Federal Reserve and Trump Administration might very well get tested. Hence, if fiscal-monetary easing push unemployment below the natural rate of unemployment and inflation (and inflation expectations) start to accelerate above 2% then the Federal Reserve sooner or later will have to act and tighten monetary conditions, which could be setting the US economy up for a boom-bust scenario with the economy initially booming one-two years and then the Fed will kill the boom by hiking interest rates aggressively.

Knowing Trump’s temperament and persona that could cause a conflict between the Fed and the Trump administration.

This is of course pure speculation, but even though the Trump administration and the Fed for now seem to favouring the same policy mix – aggressive fiscal easing and gradual rate hikes (slower than the increase the in equilibrium rate) it is unlike that this kind of old-school keynesian stop-go policies will end well.

2017 – a year of inflation?

Given these factors and others I for the first time since 2008 think that we could see inflation increase more significantly in 2017 in the US. This is of course what we to some extent want, but I am concerned that we are getting higher inflation not because the Federal Reserve has moved towards a more rule-based monetary policy framework, which ensure nominal stability, but because we are moving back towards old-school keynesian stop-go demand “management”.

PS I apologize to serious (New) Keynesians about using the term “keynesian” here. I here use the term as to refer to the kind demand management policy, which so failed during the 1970s. They where inspired by Keynesian economic think and was as such keynesian. However, that is not say that present day keynesians would necessarily agree with these policies.

PPS See also my comment over at Geopolitical Intelligence Service on why the US is “Still the Greatest”– also after Trump has become president.

Talk of further monetary stimulus from the Bank of Japan helped push the yen to a six-month low and lifted the Nikkei to a six-month high on Tuesday, and the move in Japanese assets may have further to run, analysts say.

Comments made by Bank of Japan (BOJ) governor Haruhiko Kuroda on Monday fueled speculation of further easing, after he told participants at a conference “we are ready to adjust monetary policy without hesitation if risks materialize.”

Is forward guidance important? Yes, it is tremendously important – particularly is you have little credibility about your monetary policy target. The Bank of Japan for 15 years failed to meet any monetary policy target, but since Haruhiko Kuroda became BoJ governor things have changed. His masterful forward guidance has significantly increased monetary policy credibility in Japan.

Few in the market place today can doubt that governor Kuroda is committed to meeting his 2% inflation target and that he will do whatever it takes to hit that target. Furthermore, when Kuroda says that he is “ready to adjust monetary policy without hesitation if risks materialize” he is effectively making the the Sumner Critique official policy.

Said in another way – governor Kuroda will adjust his asset purchases – if necessary – to offset any other shocks to aggregate demand (or rather money-velocity) for example in response to the planned increase in Japanese sales taxes.

As a consequence of Kuroda’s forward guidance market participants know that the BoJ will offset any effect on aggregate demand of the higher sales tax and as a consequence the expected (net) impact of the sales tax increase is zero. This of course is the Sumner Critique – an inflation targeting (or NGDP targeting) central bank will offset fiscal shocks to ensure that the fiscal multiplier is zero.

So what is happening is that market participants expect monetary easing in reaction to fiscal tightening – this is now lifting Japanese equity prices and weakening the yen. This will boost private consumption, investment and exports and thereby offset the impact on aggregate demand from the increase in sales taxes.

The Bank of Japan likely have to step up its monthly asset purchases to offset the impact of the higher sales taxes as the BoJ’s inflation target is still not fully credible. However, given Mr. Kuroda’s skillful forward guidance the BoJ will have to do a lot less in terms of an actually increase in asset purchases than otherwise would have been the case. That in my view demonstrates the importance of forward guidance.

My expectation certainly is that the plan sales tax increase in Japan will once again demonstrate that the fiscal multiplier is zero under credible inflation targeting (also that the Zero Lower Bound!) and there is in my view good reason to think that the Japanese economy will continue to recover in 2014 – to a large extent thanks to governor Kuroda’s skillful forward guidance and his commitment to hitting the BoJ’s inflation target.

I have a piece in City AM today on the impact of fiscal austerity in the UK:

FIVE years ago, nearly every macroeconomist agreed that central banks determined aggregate demand (total spending in the economy), and that fiscal stimulus was therefore unnecessary to lift depressed economies. Conversely, fiscal austerity was seen as irrelevant at best for overall growth; any impact of austerity on demand can be offset by the right monetary policy – though tax cuts could, of course, boost aggregate supply.

But the age-old discussion about the relation of fiscal policy to growth has resurfaced. Keynesian economists – including Òscar Jordà and Alan M Taylor in a paper just released by the National Bureau of Economic Research – claim that government austerity is to blame for lacklustre UK growth since 2010.

There are technical issues with the paper that make Taylor and Jordà’s precise numbers hard to evaluate. And as the economist David B Smith has noted, the important question of fiscal sustainability is not even addressed. But the more fundamental issue in the whole debate is the idea of “monetary offset”.

Following US political debate these days is like following a bad parody of a third world banana republic and even though I the deepest respect for Americans and US in general I must say it is hard not to agree with those Europeans that shake their heads these days and say “they are stupid those Americans”. Well, it is not the Americans – it is their politicians and you could say a similar thing about Europe.

The latest banana republic gimmick is the suggestion that the US Treasury should use a legal loophole to print a trillion dollar coin in the event that the US congressional majority – that’s the Republicans – would refuse to increase the so-called debt celling.

The idea in my view is completely ludicrous and it is incredible that anybody seriously would even contemplate such an idea. Anyway, is Nobel Prize winning economist Paul Krugman:

“It’s easy to make sententious remarks to the effect that we shouldn’t look for gimmicks, we should sit down like serious people and deal with our problems realistically. That may sound reasonable — if you’ve been living in a cave for the past four years.Given the realities of our political situation, and in particular the mixture of ruthlessness and craziness that now characterizes House Republicans, it’s just ridiculous — far more ridiculous than the notion of the coin.

So if the 14th amendment solution — simply declaring that the debt ceiling is unconstitutional — isn’t workable, go with the coin.”

Nobel Prize or not Krugman is wrong – as he so often is.

First, of all there is no reason to think that the US government would have to default on it’s public debt just because the debt ceiling is not increased. The monthly debt servicing costs in the US is significantly smaller than the US government’s total monthly tax revenues. It might be that the US Treasury would have to stop paying out salaries to US Congressmen and stop buying new military hardware for a while – neither would be a major lose – but the tax revenues would easily cover the debt servicing costs. That of course do not mean that I suggest that the debt ceiling should not be increased – that is US party political shenanigans that I simply don’t even want to comment on. However, it is wrong to suggest that the US government would automatically default if the debt ceiling is not increased.

Lars, wouldn’t a 1 trillion dollar coin be monetary easing? So it most be good?

What I really want to discuss is the Market Monetarist perspective on this discussion. Yes, Market Monetarists have for the past four years argued that US monetary policy has been overly tight and the reason the US recovery has been so relatively weak is the that Federal Reserve has had too tight monetary policy. That has led Market Monetarists like myself and other to call for monetary easing from the Federal Reserve.

However, at the core of Market Monetarist thinking is not the call for monetary easing and no Market Monetarist has ever said that monetary easing is the cure of all evils. Rather at the centre of Market Monetarist thinking is the call for a rule based monetary policy. An easing of monetary policy based on a trillion dollar coin is probably the most discretionary and least rule based monetary (and fiscal) idea anybody have come up with over the past four years.

Yes, Market Monetarists are certainly skeptical about central bankers ability to conduct monetary policy in a proper fashion, but that certainly do not mean that we think US politicians and bureaucrats in the US Treasury would do a better job. Far from it!

I would even go further – I don’t necessarily think that the US economy needs more quantitative easing IF the Federal Reserve started conducting monetary policy based on a transparent monetary rule like NGDP level targeting. Furthermore, if I would have to chose between an NGDP level target or a massive ramping up of quantitative easing within a discretionary framework then there is no doubt that I would choose the rule based framework. Market Monetarists are not the monetary version of discretionary Krugmanian fiscal policy.

Concluding, the trillion dollar coin idea is stupid. It is stupid because it banana republic “economic” policy based on the worst political motives without any foundation in the rule of law and a general rules based framework.

The fact is that the US government faces serious fiscal challenges. The US public debt level needs to be reduced and even if the Federal Reserve pushed back NGDP to its pre-crisis trend level I believe there would be a significant need for fiscal consolidation. There is no getting around it – debt ceiling or not, trillion dollar coin or not – fiscal policy will have to be tightened sooner or later. And if you need idea about what to cut I have some ideas about that as well (see here).

It is simple mamanomics – you can’t continue spending more money than you have. It might be that certain US policy makers would be happy if their mom raised their weekly allowances, but would they also be happy if their mom prostituted herself to do that?

PS there is no party politics in what I am saying – I have the same lack of respect for both main political parties in the US as do most Americans.

PPS Scott Sumner and Tyler Cowen also comment on the trillion dollar coin – for some reason the two gentlemen are slightly more diplomatic than I am. Josh Hendrickson, however, is as clear on the issue as I am – Josh has two posts on the trillion dollar coin. See here and here.

PPPS If you think there is a lot of James Buchanan and Friedrich Hayek in this post then I have achieved what I want to achieve. After all Friedman and Schwartz’s “Monetary History” is not the only book I read.

Update: Both Steve Horwitz and George Selgin comment on the trillion dollar coin – not surprisingly I have no reason to disagree with the two gentlemen.

Bob has a very good discussion about why the traditional keynesian thinking on monetary policy is wrong and has a good discussion about what Bob terms “Expansionary Austerity”, but what also have been termed expansionary fiscal contractions.

Bob among other points to Giavazz and Pagano’s pathbreaking 1990 study “Can Severe Fiscal Contractions Be Expansionary? Tales of Two Small European Countries.” Giavazz and Pagano in their paper highlight two cases of expansionary fiscal contractions. That is Denmark 1982-1985 and Ireland 1987-89. In both cases fiscal policy was tightened and the public deficit reduced dramatically and in both cases – contrary to what (paleo?) Keynesian theory would predicted – the economy expanded.

The Danish and Irish cases are hence often highlighted when the case is made that fiscal policy can be tightened without leading to a recession. I fully share this view. However, where a lot of the literature on expansionary fiscal contractions – including Bob’s mini survey of the literature – fails is that the role of monetary policy is not discussed. In fact I would argue that Denmark was a case of an expansionary monetary contraction – a the introduction of new strict pegged exchange rate regime strongly reduced inflation expectations (I might return to that issue in a later post…).

In all the cases I know of where there has been expansionary fiscal contractions monetary policy has been kept accommodative in the since that nominal GDP – which of course is determined by the central bank – is kept “on track”. This was also the case in the Danish and Irish cases where NGDP grew strong through the fiscal consolidation period.

My view is therefore that that fiscal austerity certainly will not have to lead to a recession IF monetary policy ensures a stable growth rate of nominal GDP. This in my view mean that we will have to be a lot more skeptical about austerity for example in Spain or Greece being successful. Spain and Greece do not have their own monetary policy and therefore the countries cannot counteract possible contractionary effects of fiscal austerity with monetary policy. That of course does not mean that these countries should not tighten fiscal policy – in my view there is no other option – but it mean that austerity in these countries are not likely to have the same positive growth effects as in Denmark and Ireland in the 1980s.

Therefore, in my view the future research on expansionary fiscal contractions should focus on the policy mix – what happened to monetary policy during the periods of fiscal consolidation? -instead of just focusing on the fiscal part of the story.

All the cases of expansionary fiscal consolidations I have studied has been accompanied by a period of fairly high and stable NGDP growth and the unsuccessful periods have been accompanied by monetary contractions. My challenge to Bob would therefore be that he should find just one case of a expansionary fiscal contraction where NGDP growth was weak…

PS the discussion above it about the business cycle perspective. Obviously if we take a longer term perspective then supply side factors dominate demand side factors. In these cases I think is it fairly easy to demonstrate that cuts in public spending will increase potential or long-term real GDP growth. I am pretty sure that Bob and I fully agree on this issue – others might not…

The short answer is the Market Monetarists do not advocate fiscal austerity. What MM’ers are arguing is that monetary dominates fiscal policy. Hence, IF fiscal policy is tightened then it will not necessarily have an negative impact on aggregate demand – or nominal GDP – if the central bank for examples targets inflation or the nominal GDP level. This is known as the Sumner Critique.

The view that monetary policy dominates fiscal policy in the determination of nominal spending in the economy makes Market Monetarists less fearful fiscal austerity than for example keynesians. Furthermore, Market Monetarists are highly skeptical about discretionary policies – both monetary and fiscal – and that leads Market Montarists to advocate rule based fiscal and monetary policy.

In addition most of the leader Market Monetarists thinkers are libertarian or conservative and as such highly skeptical about a large public sector and as a result many Market Monetarists therefore would welcome cuts in public spending. That, however, is not at the core of Market Monetarist thinking.

Finally for most Market Monetarists fiscal austerity is simply about simple arithmetics – in the long run governments cannot spend more money than they bring in. Therefore, for countries that are unable to access the global capital markets – such as Greece – there is no alternative to austerity.

I have written numerous blog posts on these issues on my blog The Market Monetarist. See some of them here:

In an earlier post I claimed that the “full” fiscal cliff would not necessarily be a disaster for the US economy – and I was probably also unusual forthcoming in my hope that US defending might be cut as a result of the fiscal cliff, but this blog is primarily about monetary policy issues so I don’t want to bore my readers with more of my views on the US defense budget. Instead I would like to recommend my readers to have a look at what the Cato Institute has to say on this issue.

In recent days several senior Republicans have come out saying they would be willing to break their anti-tax pledge as part of the fiscal cliff negotiations. At least one of those lawmakers, Senator Lindsey Graham, has said that this is because he is unwilling to let sequester budget cuts “destroy the United States military.” Cato scholars have long argued that the proposed sequester cuts would allow the United States to maintain a wide margin of military superiority, while paying substantial dividends for the U.S. economy over the long run.

Enjoy and stop worrying about lower public expenditures – after all the Sumner Critique applies: NGDP will be unaffected by lower defense spending as long as the Federal Reserve implements the Bernanke-Evans rule. By the way fiscal conservatives should be impressed with this – if the Fed keeps NGDP on track (or follow a Bernanke-Evans style policy rule) then it will remove any keynesian style opposition to fiscal consolidation.

You might also want to have a look at this excellent article by Gallaway and Vedder on the “The Great Depression of 1946”. There was of course no Great Depression in 1946 despite a massive cut in US military spending by the end of the Second World War. It is not everything Gallaway and Vedder write that I agree on, but I nonetheless think that they make a very compelling case that even drastic cuts in defense spending is unlikely to lead to any serious economic downturn. That was the case in 1946 and would be the case in 2013.

This is Paul Krugman on the effectiveness on fiscal policy and why fiscal “stimulus” will in fact not be stimulative:

“The US is currently engaged in the largest peacetime fiscal stimulus in history, with a budget deficit of around 10 percent of GDP. And this stimulus is working in the narrow sense that it has headed off the imminent risk of a deflationary spiral, and generated some economic growth. On the other hand, deficits this size cannot be continued over the long haul; USA now has Italian (or Belgian) levels of internal debt, together with large implicit liabilities associated with its awkward demographics. So the current strategy can work in the larger sense only if it succeeds in jump-starting the economy, in eventually generating a self-sustaining recovery that persists even after the stimulus is phased out.

Is this likely? The phrase “self-sustaining recovery” trips lightly off the tongue of economic officials; but it is in fact a remarkably exotic idea. The purpose of this note is to expose this hidden exoticism – to show that anyone who believes that temporary fiscal stimulus will produce sustained recovery is implicitly endorsing a rather fancy economic model, the sort of model that finance ministries would under normal circumstances regard as implausible and disreputable…

…What continues to amaze me is this: USA’s current strategy of massive, unsustainable deficit spending in the hopes that this will somehow generate a self-sustained recovery is currently regarded as the orthodox, sensible thing to do – even though it can be justified only by exotic stories about multiple equilibria, the sort of thing you would imagine only a professor could believe. Meanwhile further steps on monetary policy – the sort of thing you would advocate if you believed in a more conventional, boring model, one in which the problem is simply a question of the savings-investment balance – are rejected as dangerously radical and unbecoming of a dignified economy.”

Wauw! What is this? What happened to the keynesian Krugman? Isn’t he calling for fiscal easing anymore? Well yes, but I am cheating here. This is Paul Krugman, but it is not today’s Paul Krugman. This is Paul Krugman in 1999 – and he is talking about Japan and not the US. I simply replaced “Japan” with “the US” in the Krugman quote above.

Sometimes simple macroeconomic models can help us understand the world better and even though I am not uncritical about the IS/LM model it nonetheless has some interesting features which from time to time makes it useful for policy analysis (if you are careful).

However, a key problem with the IS/LM model is that the model does not take into account – in its basic textbook form – the central bank’s policy rule. However, it is easy to expand the model to include a monetary policy rule.

I will do exactly that in this post and I will use the Federal Reserve’s new policy rule – the Bernanke-Evans rule – to analysis the impact of the so-called fiscal cliff on a (very!) stylised version of the US economy.

We start out with the two standard equations in the IS/LM model.

The money demand function:

(1) m=p+y-α×r

Where m is the money supply/demand, p is prices and y is real GDP. r is the interest rate and α is a coefficient.

Aggregate demand is defined as follows:

(2) y=g-β×r

Aggregate demand y equals public spending and private sector demand (β×r), which is a function of the interest rate r. β is a coefficient. It is assumed that private demand drops when the interest rate increases.

This is basically all you need in the textbook IS/LM model. However, we also need to define a monetary policy rule to be able to say something about the real world.

I will use a stylised version of the Bernanke-Evans rule based on the latest policy announcement from the Fed’s FOMC. The FOMC at it latest meeting argued that it basically would continue to expand the money base (in the IS/LM the money base and the money supply is the same thing) to hit a certain target for the unemployment rate. That means that we can define a simple Bernanke-Evans rule as follows:

(3) m=λ×U

One can think of U as either the unemployment rate or the deviation of the unemployment rate from the Fed’s unemployment target. λ is a coefficient that tells you how aggressive the fed will increase the money supply (m) if U increases.

We now need to model how the labour market works. We simply assume Okun’s law holds (we could also have used a simple production function):

(4) U=-δ×y

This obviously is very simplified as we totally disregard supply side issues on the labour market. However, we are not interested in using this model for analysis of such factors.

It is easy to solve the model. We get the LM curve from (1), (3) and (4):

LM: r= y×(1+δ×λ)⁄α+(1/α)×p

And we get the IS curve by rearranging (2):

IS: r =(1/β)×g-(1/β)×y

Under normal assumptions about the coefficients in the model the LM curve is upward sloping and the IS curve is downward sloping. This is as in the textbook version.

Note, however, that the slope of the LM does not only depend on the money demand’s interest rate elasticity (α), but also on how aggressive (λ) the fed will react to an increase in unemployment.

The Sumner Critique applies if λ=∞

The fact that the slope of the LM curve depends on λ is critical. Hence, if the fed is fully committed to its unemployment target and will do everything to fulfill (as the FOMC signaled when it said it would step up QE until it hit its target) then λ equals infinity (∞) .

Obviously, if λ=∞ then the LM curve is vertical – as in the “monetarist” case in the textbook version of the IS/LM model. However, contrary to the “normal” the LM curve we don’t need α to be zero to ensure a vertical LM curve.

Hence, under a strict Bernanke-Evans rule where the fed will not accept any diviation from its unemployment target (λ=∞) the (government) budget multiplier is zero and the so-called Sumner Critique therefore applies: Fiscal policy cannot increase or decrease output (y) or the unemployment (U) as any fiscal “shock” (higher or lower g) will be fully offset by the fed’s actions.

The Bernanke-Evans rule reduces risks from the fiscal cliff

It follows that if the fed actually follows through on it commitment to hit its (still fuzzy) unemployment target then in the simple model outlined above the risk from a negative shock to demand from the so-called fiscal cliff is reduced greatly.

This is good news, but it is also a natural experiment of the Sumner Critique. Imagine that we indeed get a 4% of GDP tightening of fiscal policy next year, but at the same time the fed is 100% committed to hitting it unemployment target (that unemployment should drop) then if unemployment then increases anyway then Scott Sumner (and myself) is wrong – or the fed didn’t do it job well enough. Both are obviously very likely…

I am arguing that I believe the model presented above is the correct model of the US economy. The purpose has rather been to demonstrate the critical importance of a the monetary policy rule even in a standard textbook keynesian model and to demonstrate that fiscal policy is much less important than normally assumed by keynesians if we take the monetary policy rule into account.

Market Monetarists have stressed it again and again – the European crisis is primarily a monetary crisis rather than a financial crisis and a debt crisis. Tight monetary conditions is reason for the so-called debt crisis. Said in another way it is the collapse in nominal GDP relative to the pre-crisis trend that have caused European debt ratios to skyrocket in the last four years.

That is easily illustrated – just see the graph below:

I have simply plotted the change in public debt to GDP from 2007 to 2012 (2012 are European Commission forecasts) against the percentage change in nominal GDP since 2007.

The conclusion is very clear. The change in public debt ratios across the euro zone is nearly entirely a result of the development in nominal GDP.

The “bad boys” the so-called PIIGS – Portugal, Ireland, Italy, Greece and Spain (and Slovenia) are those five (six) countries that have seen the most lackluster growth (in fact decline) in NGDP in the euro zone. These countries are obviously also the countries where debt has increased the most and government bond yields have skyrocketed.

This should really not be a surprise to anybody who have taken Macro 101 – public expenditures tend to increase and tax revenues drop in cyclical downturns. So higher budget deficits normally go hand in hand with weaker growth.

The graph interestingly enough also shows that the debt development in Greece really is no different from the debt development in Germany if we take the difference in NGDP growth into account. Greek nominal GDP has dropped by around 10% since 2007 and that pretty much explains the 50%-point increase in public debt since 2007. Greece is smack on the regression line in the graph – and so is Germany. The better debt performance in Germany does not reflect that the German government is more fiscally conservative than the Greek government. Rather it reflects a much better NGDP growth performance. So maybe we should ask the Bundesbank what would have happened to German public debt had NGDP dropped by 10% as in Greece. My guess is that the markets would not be too impressed with German fiscal policy in that scenario. It should of course also be noted that you can argue that the Greek government really has not anything to reduce the level of public debt – if it had than the Greece would be below to the regression line in the graph and it is not.

There are two outliers in the graph – Ireland and Estonia. The increase in Irish debt is much larger than one should have expected judging from the size of the change in NGDP in Ireland. This can easily be explained – it is simply the cost of the Irish banking rescues. The other outlier is Estonia where the increase in public debt has been much smaller than one should have expected given the development in nominal GDP. In that sense Estonia is really the only country in the euro zone, which have improved its public finances in any substantial fashion compared to what would have been the case if fiscal austerity had not been undertaken. The tightening of fiscal policy measured in this way is 20-25% of GDP. This is a truly remarkable tightening of fiscal policy.

Imagine, however, for one minute that Greece had undertaken a fiscal tightening of a similar magnitude as Estonia and assume at the same time that it would have had no impact on NGDP (the keynesians are now screaming) then the Greek budget situation would still have been horrendous – public debt would have not increase by 50% %-point of GDP but “only” by 30%-point. Greece would still be in deep trouble. This I think demonstrates that it is near impossible to undertake any meaningful fiscal consolidation when you see the kind of collapse in NGDP that you have seen in Greece.

Concluding, the European debt crisis is not really a debt crisis. It is a monetary crisis. The ECB has allowed euro zone nominal GDP to drop well-below its pre-crisis trend and that is the key reason for the sharp rise in public debt ratios. I am not saying that Europe do not have other problems. In fact I think Europe has serious structural problems – too much regulation, too high taxes, rigid labour markets, underfunded pension systems etc. However, these problems did not cause the present crisis and even though I think these issues need to be addressed I doubt that reforms in these areas will be enough to drag us out of the crisis. We need higher nominal GDP growth. That will be the best cure. Now we are only waiting on Draghi to deliver.

PS The graph above also illustrate how badly wrong Arthur Laffer got it on fiscal policy in his recent Wall Street Journal article – particular in his claim that Estonia had been got conducting keynesian fiscal stimulus. See here, here and here.